Risk Management Quiz

• The notes are for ACSG1614 at the University of the Free State for the academic year 2023 only and should not be distributed.
• The notes provide a brief introduction to Actuarial Science and related fields; concepts are simplified for first-time readers.
• The quality or correctness of the notes cannot be guaranteed, as they have not been reviewed.
• Opinions, examples, or statements given in these notes or made in class should not be seen as advice.

Understanding Risk

• In actuarial terms, risk involves uncertainty and potential downside.
• A risk or risk event may also be called a peril.

Forms of Risk

• Pure risk involves only a potential downside or no change but no possible gains.
  • An example of pure risk is car ownership, where there could be damage or theft, or no damage.
• Speculative risk involves a potential downside, no loss, or a potential upside.
  • Investing is an example of this form of risk, where profit, break even, or a financial losses are possible.
• Particular risk pertains to an individual or a specific group.
  • It can be either pure or speculative and can affect life, property, income, health, or wealth.
• Fundamental risk pertains to an entire population and is almost always pure.
  • Examples are natural phenomena, social problems, and economic disasters.

Defining Risk

• A clear definition of risk involves specifying events.
• Vague definitions such as "weather" aren't clear enough.
• Specific examples includes "Raining more than 100mm in a day" or "Wind of 50 km/h +".

Risk Identification

• Common individual risks includes death, disability, cellphone loss/theft/damage, and failing academically.
  • All of these can be classified as pure and particular risks.
• Broader risks can be an economic downturn, AI employment, war, and extreme weather.
  • These risks are typically fundamental and more easily overlooked.

Insurability

• Insurable risks includes death, disability, property, and medical expenses.
• Insurers use life insurance, income protectors, critical illness, and medical schemes to cover each one respectively.
• Risks often not covered includes economic downturns, AI, and war.

Qualities for Insurability

• Risk pooling involves statistical clarity and profit.
• Risks should be independent, ensuring one does not cause others.
• The risk should be associated with some loss, not profit.
• There should be sufficient data to price insurance.
• Measurable to calculate the amount of loss that occurs.
• Upper limits to insurance payout should be set.
• The probability of the risk happening should be relatively low.
• Moral hazard and adverse selection need to be limited.
• The insurer should have many customers with uncorrelated risks.

Risk Management Steps

• Risk management involves three key steps: identify, quantify and manage.

Step 1 - Identify

• Listing all potential risks is the crucial first step in risk management.
• Risks that are not identified are treated as non-existent.
• Considerations include property, health, income, and liability.

Step 2 - Quantify

• Quantification involves assessing risks and determining their potential costs.
• Done by multiplying the probability of an event by its consequence.
  • If the risk of car damage is 30% with an average cost of R50 000, the expected loss is R15 000.

Step 3 -Manage

• Managing identified/quantified risks can be done a number of ways, including:
  • Avoidance
  • Reduction
  • Sharing
  • Transfer (insurance)
  • Finance
  • Postponement/Deferral/Delay
  • Retain

Risk Factors vs Rating Factors

• Risk factors directly influence the probability/consequence of a risk event.
• Rating factors predict probability via measurable proxies.
• Car insurance example of risk vs rating factors:
  • The driver's ability can be looked at via age/claims record
  • The amount of time on the road through occupation/distances travelled
  • Safety features via the car's color/make/model

Role of Insurance

• Insurers change uncertainty for certainty in return for premium.
• The premium should equal the risk being posed.
• The risk premium is the compensation to cover losses.
• Insurers also incur design, marketing administrative and commission expenses.
• Insurers add these onto the total premium, which is known as the office premium.
• There is also a profit motive.
• The office premium can be calculated as:
  • Risk Premium + Costs + Profit Loading

Advantages of Insurance

• Capital Efficiencies
• Relieving Burden on State
• Destitution
• Job Creation
• Financial Stability
• Reduces Risk

Types of Losses

• Loss classifications are financial, physical, and emotional.
• Financial losses includes property damage, income loss, and others.
  • Generally have direct costs and losses associated.
• Physical losses such as health issues, limb damage, or loss of life are indirect.
  • Can impact future income and overall quality of life.
• Emotional losses impacts quality of life, i.e. PTSD, trauma, sentimental value.
  • More difficult to quantify.

Forms of Insurance Benefit

• Insurance pay-outs are done in the following four ways:
  • Reinstatement, also called Indemnity, brings you back into the same financial position.
  • Minus excess, where a fixed/percentage charge you will always need to pay is deducted
  • Pre-determined lump sum or income, as the benefit is pre-determined
  • Externally determined, wherein the court determines the benefit

Benefit for Loss Type

• Benefits for the type of loss:
  • Properties are replaced, repairs made, or refunds are given.
  • Income losses can be indemnified.
  • Medical bills paid for health benefits, sometimes with some pre-determined amounts
  • Death: indemnity not possible, requires some pre-determined benefits
  • Difficult to confirm emotional losses and provide insurance.

Simple Example of Risk Calculation

• Cellphone with a value of R5,000 with a 10% chance of being stolen annually.
• The annual risk premium for such an insurance policy will be R500.
• If there are 100 insured cellphones:
  • Probability of theft on 100 cellphones would be 10 out of 100.
  • Therefore the total premium will be: 10 * 5000
  • The cost per policy will be: (10 * 5000)/100 = 500 per policy/premium unit
  • The formula used here is: Value= Probability * Cost per policy
• The office premium also needs to include costs such as administration fees.
  • Office Premium = Risk Premium + Costs + Profit Loading
  • The office premium can be calculated as: 500 + 10+(Premium * 0.1) + 15

Other Calculations

• If 300 out of every 100,000 cars crash annually, the probability of car crash is 300/10000, or 0.003.